Financial Analysis of Development Projects

[Pages:32]School of Business Montclair State University

Financial Analysis of

Development Projects

July 2011

Phillip LeBel, Ph.D., Director Center for Economic Research on Africa

Montclair State University (translated and updated from the French original version, ?2010,2009,2004,2001,1999)

lebelp@mail.montclair.edu

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Acknowledgements This module was prepared originally in French by Alan Johnson, Deputy Administrator of the U.S. AID project of the ENEA School in Dakar, Senegal, and by Richard Vengroff, Dean, Division of International Affairs at the University of Connecticut at Storrs, with an update and English translation by Phillip LeBel, Director of the Center for Economic Research on Africa (CERAF) at Montclair State University in Upper Montclair, New Jersey. Recent versions reflect revisions and extensions by the author.

Overview The following exercises have been developed to introduce basic notions of financial analysis as used in the evaluation of development projects. They have been used in management training seminars in Africa and in the U.S. for the past several years, primarily to French-speaking participants, and are now being made available to English speaking audiences. While many project administrators often have a good working knowledge and experience with development issues, they often may lack training in the tools of financial analysis in the context of project management. This module is designed as an introduction to the most commonly used tools and draws on examples within an applied developed setting.

The module is divided into three parts. Part one concentrates on a selfcontained set of exercises on present value calculations. While based on individual work by participants, there are several ways that these materials can be structured for group participation and presentations. Wherever appropriate, participants should also ask questions directly to instructors to ensure a good mastery of materials. Part two is based on calculating the net present value of a project, its interpretation and its application within a development project setting. Part three uses a case study that draws on concepts and techniques developed throughout the preceding sections. Participants first work individually on the case study, then are organized into groups to share their findings among each other. Then, using discount rates which the instructor assigns to each group, participants develop a project analysis evaluation tableau on flip charts, or, where available, on computer spreadsheets, to evaluate the acceptability of the case study project.

A. On the Range and Scope of Financial Markets Financial markets play a crucial role in the allocation of investment resources. They do so not just in terms of decisions that take place over time. They also manage the implicit and explicit risks that are inherent in any time-based decision. This carries particular significance for developing economies, and efforts to develop local financial institutions is an important step in achieving sustainable economic growth. As such, we first take a look at the range and scope of financial markets.

If production decisions were made in the absence of durable capital equipment, there would be little need for financial markets. Yet because modern economic growth takes place within a broad spectrum of the production and use of capital goods that there is a need for a corresponding set of financial institutions and contracts to allocate these resources in an efficient manner. Financial markets allow for the scheduling of financial flows of an investment project in such a way that the costs and benefits may be evaluated in a consistent fashion. Such markets involve a broad range of instruments that cover debt and equity finance, along with various insurance tooks to manage the corresponding levels of risk.

To have some idea of the scope of these instruments, let us look first at the scale of the global bond market. Based on statistics from the World Bank, the 1995 value of the global capital market stood at $U.S. 27.59 trillion, and as of 2010 stood at over $U.S. 45 trillion. In 1997, the assets of the various financial institutions participating in this market were valued at $U.S. 24.13 trillion, of which some $U.S.23.69 trillion represented the current value of equity markets, and with bank loans operating at a level of $U.S. 26.49 trillion. When compared to the global value of production, the capitalized value of financial markets represented some three times the value of global economic production.

Figure 1 below provides a breakdown of the size of the global bond market in 1997. As can be seen, The United States accounted for just under onehalf of all bonds issued, followed by Japan at 18 percent, and Germany at 12 percent.

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Figure 1

Bonds are issued in various denominations with various maturities over differing interest rates. They can be issued by government agencies as well as by private firms. Although firms can and do issue bonds, for the most part it is government agencies that dominate this type of market. As can be seen in Figure 2 below, governments account for more than half of all outstanding bonds, a proportion that has varied little over the years.

Figure 2

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The choice of financing for capital investments is driven by several considerations. One is the primacy of claims over the borrowing institution. In the case of bonds, no ownership is conferred, and bonds carry a priority claim over equities. For this reason, bonds generally carry lower levels of interest than the underlying rates of interest associated with equity markets, as will be noted below.

The pricing of financial assets depends on several measures, or ratios, and for which whose prices adjust in response to changes in the level and distribution of information. In developed country markets at least, financial economists have contended that within all of the financial fluctuations that we observe over time, the pricing of these markets is efficient in that asset values reflect current and future economic conditions surrounding any particular asset.

Figure 3

30.00

S&P 500 Price-Earnings Ratio

25.00

1894

1921

1931

20.00 15.00 10.00

5.00

1893

1930 1934

1992

1888 1896

1961

19931997

187111818718741875187687778918188385181889911819851918790910910931019590107198191191019111912913145119912910912193192192519269272891913931319519319371938194919401941194219431944945467191591513915196195958690

1199616697169971 1973

19817990 1996 1995

19851989

1974 11997756

1983 1981

1988

P/E Ratio Basic Statistics:

Mean (1871-1997):

1918 1916

19149850

1979

Quadratic Time Trend: Y = 0.0003x2 - 0.0393x + 14.684

R2 = 0.0073

0.00 1871 1878 1885 1892 1899 1906 1913 1920 1927 1934 1941 1948 1955 1962 1969 1976 1983 1990 1997 2004

P/E Ratio

P/E Ratio Trend

In deciding among various types of financing instruments, one way to establish a common denominator is to derive a corresponding yield, or rate of return. For bonds, this is a straightforward calculation in which the absolute level of interest earned over time is divided by the corresponding price of the bond. For stocks, the yield is reflected in the ratio of the earnings plus the appreciation in the value of a share of stock divided by its price. While financial markets are considered to be relatively efficient, there are several measures that are used as benchmarks to determine if prices are either over or undervalued.

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One such measure is the price-earnings ratio, or the reciprocal of the rate of return. Financial evaluations are undertaken by any number of firms to determine if bonds or stock prices are mis-specified by some historical reference. One firm, Standard and Poors, has tracked a basket of 500 stocks over time to provide a reference on stock pricing efficiency. In figure 3 above, we show the S&P 500 price-earnings ratio for the 1871-1997 time period, and plot the corresponding long term trend. The higher is the P-E ratio for any given time period relative to a long-term trend, the more the stock is over-priced, and vice-versa. While this benchmark is not an absolute guarantee for the determination of an efficient equity price level, it does serve as a first-order approximation.

One principle guides the pricing of financial assets and their associated rates of return: the price should correspond to the pure time-value of money plus a given risk premium. The more volatile is an asset, the higher the level of risk, and for which the average rate of return should be higher than a riskfree asset's rate of return. In Figure 4 below, we show a comparison of the annual rate of return on stocks, bonds, and treasury bills for the 1926-1995 time period. A quick inspection suggests that stocks are more volatile than bonds, and in turn more volatile than treasury bills. Not surprisingly, there is a direct relationship between the mean rate of return and the corresponding level of volatility.

Figure 4

Nominal Rates of Return to U.S. Bills, Bonds, and Stocks

60.00

40.00

20.00

0.00 1926 1930 1934 1938 1942 1946 1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010

-20.00

-40.00 -60.00

Mean Rate of Return St.Deviation C.Variation

Stocks 7.40

19.90 2.69

Bonds 5.58 9.29 1.66

Bills

Bonds

Stocks

Source: Center for Research in Security Prices

Bills 3.81 3.27 0.86

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If the yields on stocks, bonds, and bills differ in proportion to the underlying level of risk, we have a reasonable solution to the problem of their prices, i.e, the prices are efficient in that they reflect all underlying information regarding the present and future state of events surrounding the asset. This said, we can not state at this point that once we have a given level of accuracy in the measurement of risk we have a clear choice as to how to select among the various alternatives.

To illustrate the question of risk selection, consider the various distributions listed below in Figure 5. Each distribution is symmetric in that the the area to the left of each peak is identical to the area to its right. On the X-axis we have the various possible outcomes from a given choice, and as can be seen, this includes some negative ones as well as positive ones. On the Y-axis we have the various probabilities that are associated with each possible outcome. The expected value is the sum of the products of each probability multiplied by its corresponding outcome.

Let us now look at two of the symmetric distributions, namely, distribution A and B. Which of these would you prefer? They each have the same expected outcome as can be seen by the peaks corresponding to the same outcome on the X-axis. To answer this question, consider what a riskless choice would look like ? it would be a perfectly vertical line, with no distribution tails on either side. With this in mind, it is clear that distribution B has less of a spread, and thus less risk, than distribution A. If these were the only choices you would confront, if you are normally risk averse, you would prefer distribution B to distribution A. Now consider distribution C and D. they both have a higher expected outcome than either distribution A or B. If the choice were between distribution C and D alone, the risk averse logical choice would be C as it has a smaller level of risk than distribution D.

0.0250 0.0200 0.0150 0.0100 0.0050 0.0000

- 8 Figure 5 Alternative Symmetric Distributions

B.

A.

C.

D.

We have now considered the easier choices. But now consider which choice to make is it is only between distribution C or B. Distribution C has a higher expected value than distribution B, but it also has a higher level of risk. The choice in this case is not obvious. In fact, it depends entirely on the risk tolerance, or preference, of the individual making the decision. For some individuals, the higher expected value of distribution C is sufficiently higher than for distribution B, in which case C is adopted. However, for others, the risk premium is not sufficient to overcome their level of risk aversion. In this case, they would select distribution B over distribution C. Either choice is acceptable and consistent with the notion of efficient markets in that markets allow for and recognize differences in individuals' perceptions and attitudes toward risk. In short, in order to enjoy a higher outcome, one has to undertake some additional level of risk.

Although we have now provided a mechanism for the measurement of risk, thus far we have looked only at financial risk. Yet financial risk is interrelated to other factors, namely, political, economic, and environmental risks. For this reason, particularly in the context of developing countries that do not issue sovereign debt, there is a need to provide some measure of the overall risk climate in a given country. The World Bank periodically publishes such an index, as prepared by the International Country Risk Group, or ICRG. This index, which ranges from 0 to 100, with higher values inversely related to the level of aggregate country risk, provides a proxy measure of the level of risk as countries engage in the continuing process of economic growth and development.

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